Bonds jump in 2025, on track for their best year since the 2020 bond rally

Almost everything has fallen into place for bonds lately.

The Federal Reserve has cut interest rates. Growth in employment and consumer spending is slowing, raising hopes of further cuts, but not suggesting an imminent recession that would threaten corporate balance sheets. Inflationary pressures continued to moderate, despite concerns that tariffs imposed by President Trump would push up prices.

The widely followed Bloomberg US Aggregate Bond Index returned about 6.7% in 2025, accounting for price changes and interest payments. This sets him up for the best year since 2020.

Bonds had regained some ground after the Fed’s inflation-fighting campaign fueled a historically bad 2022. The Bloomberg Agg Index, comprised largely of Treasuries, investment-grade corporate bonds and agency mortgage-backed securities, returned 5.5% in 2023, although it nearly stagnated in 2024.

Investors said 2025 would be different. The rise rewarded investors still stung by the unusual volatility that followed the Covid-19 era inflation surge. Unlike previous years, the index’s returns far outpaced those of short-term Treasuries, the other main choice for investors looking for a safe alternative to stocks.

“It’s definitely been more fun attending client meetings this year as a bond manager,” said Cal Spranger, fixed income manager at Badgley Phelps Wealth Managers. “A few years ago, I wasn’t invited on any dates.”

Even though yields on government and corporate bonds have gradually fallen, they remain well above the paltry levels seen over much of the past decade – and investors want to hold on to them while they can.

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Earlier this year, massive but brief sell-offs in U.S. Treasuries raised concerns that the bond market might finally buckle under the pressure of outsized U.S. borrowing. The size of the budget deficit can influence returns, because a larger deficit means the government must borrow more by issuing Treasury bills and, in turn, attract demand for that debt with higher rates.

The decline in rates has largely overcome all these concerns, because bonds issued when rates are high become more valuable when rates are expected to fall. At the start of the year, investors were unsure whether the Fed would be able to cut rates, given persistent inflation and expectations that Trump would pursue expansionary fiscal policies. But the slowdown in the labor market has already led to two reductions this year, with another reduction still possible.

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As a result, Treasury yields, which fall when bond prices rise, fell. The yield on the 10-year note has fallen nearly half a percentage point this year, settling at 4.147% on Friday.

U.S. Secretary of the Treasury Scott Bessent and U.S. President Donald Trump attend the White House Digital Assets Summit in the State Dining Room of the White House March 7, 2025 in Washington, DC. (Anna Moneymaker/Getty Images/Getty Images)

It also helps bonds: The Trump administration has kept a close eye on the market, sometimes entering it during periods of turbulence. The president suspended most of his so-called reciprocal tariffs in April due to “Yippy” bond investors. Treasury Secretary Scott Bessent said maintaining low yields on long-term Treasuries was a priority for the administration. They serve as a benchmark for borrowing costs for everything from mortgages to student loans.

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Many threats still weigh on the rally. The path forward for an interest rate cut has been muddied by divisions among central bank officials, with some questioning the likelihood of a rate cut in December. Federal Reserve Chairman Jerome Powell warned in October that the Fed was “far away” from deciding whether to cut rates next month, an unusually blunt remark from a central banker.

Investors now think a December rate cut is pretty much a coin toss. As of Friday, futures markets were pricing in a roughly 46% chance of a decline, according to CME Group data, up from about 67% a week earlier.

Some fear that the U.S. credit market is overheating and that historically high valuations of corporate debt mask market excesses and do not adequately reward investors who take risks. The additional yield, or spread, that investors get from holding investment-grade corporate bonds over Treasuries fell to 0.72 percentage points in September, the lowest level since the late 1990s. It has since risen slightly to 0.83 percentage points.

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Some analysts warn that the US government’s budget deficit risks once again weighing on the bond market. The deficit stood at $1.8 trillion for fiscal 2025, virtually unchanged from 2024.

“It will definitely be a problem at some point,” said Mike Goosay, chief investment officer and global head of fixed income at Principal Asset Management. “You can only borrow so much before investors start to walk away from you.”

Many see the good times continuing, believing that interest rates still need to fall despite the recent rise in uncertainty.

Matt Brill, senior portfolio manager and head of North America investment grade credit at Invesco, said his team favors short-term bonds, believing that upcoming economic data will push the Fed to continue cutting emissions.

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“There are not many layoffs, but there is also no job creation,” he said. “I think the Fed is looking at this and it’s concerning to them.”

Write to Krystal Hur at krystal.hur@wsj.com and Sam Goldfarb at sam.goldfarb@wsj.com